IFRS 9, IFRS 15 adopted, policies, para 35(c), no alternative use, enforceable right to payment for performance to date

BAE Systems plc – Half year report – 30 June 2018

Industry: manufacturing; aerospace

Notes to the condensed half-yearly financial statements (extract)

  1. Preparation (extract)

New and amended standards adopted by the Group

A number of new or amended standards became applicable for the current reporting period and the Group changed its accounting policies and, where applicable, made retrospective adjustments as a result of adopting:

– IFRS 9 Financial Instruments, and

– IFRS 15 Revenue from Contracts with Customers.

The impact of the adoption of these standards and the new accounting policies is disclosed in note 10. Following the adoption of IFRS 15 Revenue from Contracts with Customers, the Group continues to recognise revenue and profit recognition as one of its critical accounting policies, owing to the complexity, judgement and estimation in its application and impact on the financial statements. Note 10 provides more details on the Group’s application of IFRS 15 and its new accounting policy for the new standard.

  1. Change in accounting policies

This note explains the impact of the adoption of IFRS 9 Financial Instruments, and IFRS 15 Revenue from Contracts with Customers, on the Group’s financial statements and also discloses the new accounting policies that have been applied from 1 January 2018, where they are different from those applied in earlier periods.

Impact on financial statements

As a result of changes in the Group’s accounting policies, prior year financial statements have been restated for the adoption of IFRS 15 Revenue from Contracts with Customers. As explained below, IFRS 9 was adopted without restating comparative information.

The following tables show the adjustments recognised for each individual line item. Line items that are not affected by the changes have not been included. As a result, the sub-totals and totals disclosed cannot be recalculated from the numbers provided. The adjustments are explained in more detail by standard below.

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IFRS 9 Financial instruments – impact of adoption

IFRS 9 replaces the provisions of IAS 39 that relate to recognition, classification and measurement of financial assets and financial liabilities, de-recognition of financial instruments, impairment of financial assets and hedge accounting. The adoption of IFRS 9 Financial Instruments from 1 January 2018 resulted in changes in accounting policies however no adjustments were required to the amounts recognised in the financial statements in previous periods. The new accounting policies are set out below.

Classification and measurement

On 1 January 2018, the Group has classified its financial instruments in the appropriate IFRS 9 categories.

The derivative financial instruments designated as cash flow hedges and fair values hedges under IAS 39 at 31 December 2017 continue to qualify for hedge accounting under IFRS 9 at 1 January 2018 and are therefore treated as continuing hedges.

Derivative financial instruments that did not qualify for hedge accounting under IAS 39 were classified in the “fair value through profit or loss” category and gains and losses were recognised in the income statement in the period. There is no change to the classification of these financial instruments under IFRS 9 as they fail the contractual cash flow characteristics test in IFRS 9 (4.1.2(b)) and (4.1.2A(b)).

Financial assets previously classified in the “loans and receivables” category and measured at amortised cost under IAS 39 (being trade and other receivables and amounts owed by equity accounted investments) continue to be classified in the “amortised cost” category under IFRS 9.

Impairment of financial assets

The Group has three types of financial assets that are subject to IFRS 9’s new expected credit loss model:

– trade and other receivables;

– contract receivables; and

– amounts owed by equity accounted investments.

Trade and other receivables, and contract receivables, do not contain a significant financing element and therefore expected credit losses are measured using the simplified approach permitted by IFRS 9, which requires expected lifetime losses to be recognised from the initial recognition of the receivables.

The Group has assessed credit risk in relation to defence-related sales to government customers or sub-contractors to governments and believes it be extremely low, therefore no expected credit loss provision is required for these trade and other receivables, or contract receivables. The Group considers expected credit losses for non-government commercial customers, however this risk is not expected to be material to the financial statements.

Amounts due from equity accounted investments primarily relate to trading balances with no significant financing element, in accordance with IFRS 15. The simplified approach is therefore used for these balances.

While cash and cash equivalents are also subject to the impairment requirements of IFRS 9, the identified impairment loss was immaterial.

There was no IFRS 9 impact on retained earnings at 1 January 2018.

IFRS 9 Financial Instruments – accounting policies applied since 1 January 2018

Investments and other financial assets

Classification

From 1 January 2018, the Group classifies its financial assets in the following measurement categories:

  • those to be measured subsequently at fair value (either through other comprehensive income, or through profit or loss); and
  • those to be measured at amortised cost.

Measurement

At initial recognition, the Group measures a financial asset at its fair value plus, in the case of a financial asset not measured at fair value through profit or loss, transaction costs that are directly attributable to the acquisition of the financial asset.

The Group subsequently measures derivative financial instruments at fair value. Gains and losses on derivative financial instruments that do not qualify for hedge accounting are recognised in the income statement for the period. Where a derivative financial instrument is designated as a cash flow hedge, the effective portion of any change in the fair value of the instrument is recognised in other comprehensive income and presented in the hedging reserve in equity. Amounts recognised in equity are reclassified from reserves into the cost of the underlying transaction and recognised in the income statement when the underlying transaction affects profit or loss. The ineffective portion of any change in the fair value of the instrument is recognised in profit or loss immediately. Where a derivative financial instrument is designated as a fair value hedge, changes in the fair value of the underlying asset or liability attributable to the hedge risk, and gains and losses on the derivative financial instrument, are recognised in the income statement for the period.

The Group subsequently measures trade and other receivables, contract receivables and amounts due from equity accounted investments at amortised cost.

The Group subsequently measures all equity investments at fair value and has elected to present fair value gains and losses on equity investments in other comprehensive income. There is therefore no subsequent reclassification of fair value gains and losses to profit or loss following a disposal of the investment.

Impairment

For trade and other receivables, contract receivables and amounts due from equity accounted investments, the Group applies the simplified approach permitted by IFRS 9, which requires expected lifetime losses to be recognised from initial recognition of the receivables.

Derivatives and hedging

Fair value through profit or loss

Gains and losses on derivative financial instruments that do not qualify for hedge accounting are recognised in the income statement for the period.

Cash flow hedges

Where a derivative financial instrument is designated as a hedge of cash flows relating to a highly probable forecast transaction (income or expense), the effective portion of any change in the fair value of the instrument is recognised in other comprehensive income and presented in the hedging reserve in equity. The ineffective portion of any change in the fair value of the instrument is recognised in the income statement immediately.

Fair value hedges

Where a derivative financial instrument is designated as a fair value hedge, changes in the fair value of the underlying asset or liability attributable to the hedged risk, and gains and losses on the derivative instrument, are recognised in the income statement for the period.

Financial liabilities

There are no changes to the accounting policies in respect of loans, overdrafts, and trade and other payables, which continue to be measured at amortised cost, except where fair value hedge accounting is applied.

IFRS 15 Revenue from Contracts with Customers – impact of adoption

As a result of the adoption of IFRS 15 Revenue from Contracts with Customers from 1 January 2018, the following adjustments were made to restate the amounts recognised in the balance sheet at 31 December 2017:

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At 30 June 2018, trade, other and contract receivables includes contract receivables of £2,137m (31 December 2017 £1,420m).

At 30 June 2018, trade and other payables includes contract liabilities of £3,068m (31 December 2017 £3,551m).

The impact of adoption on the Group’s retained earnings at 31 December 2017 and 31 December 2016 is as follows:

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IFRS 15 Revenue from Contracts with Customers – accounting policies applied since 1 January 2018

The Group has adopted IFRS 15 fully retrospectively in accordance with paragraph C3(a).

Comparatives for the half year ended 30 June 2017 and the year ended 31 December 2017 have been restated. The following expedients have been or will be used in accordance with paragraph C5:

  • revenue in respect of completed contracts that begin and end in the same accounting period has not been restated;
  • revenue in respect of completed contracts with variable consideration reflects the transaction price at the date the contracts were completed; and
  • in the financial statements for the year ending 31 December 2018, the comparative information for the year ending 31 December 2017 will not disclose the amount of the transaction price allocated to the remaining performance obligations or an explanation of when the Group expects to recognise that amount as revenue.

Following the adoption of IFRS 15, the Group’s accounting policy in respect of revenue is as follows:

Revenue represents income derived from contracts for the provision of goods and services by the Company and its subsidiary undertakings to customers in exchange for consideration in the ordinary course of the Group’s activities.

Performance obligations

Upon approval by the parties to a contract, the contract is assessed to identify each promise to transfer either a distinct good or service or a series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer. Goods and services are distinct and accounted for as separate performance obligations in the contract if the customer can benefit from them either on their own or together with other resources that are readily available to the customer and they are separately identifiable in the contract.

Transaction price

At the start of the contract, the total transaction price is estimated as the amount of consideration to which the Group expects to be entitled in exchange for transferring the promised goods and services to the customer, excluding sales taxes. Variable consideration, such as price escalation, is included based on the expected value or most likely amount only to the extent that it is highly probable that there will not be a reversal in the amount of cumulative revenue recognised. The transaction price does not include estimates of consideration resulting from contract modifications, such as change orders, until they have been approved by the parties to the contract. The total transaction price is allocated to the performance obligations identified in the contract in proportion to their relative stand-alone selling prices. Given the bespoke nature of many of the Group’s products and services, which are designed and/or manufactured under contract to the customer’s individual specifications, there are typically no observable stand-alone selling prices. Instead, stand-alone selling prices are typically estimated based on expected costs plus contract margin consistent with the Group’s pricing principles.

Revenue and profit recognition

Revenue is recognised as performance obligations are satisfied as control of the goods and services is transferred to the customer.

For each performance obligation within a contract, the Group determines whether it is satisfied over time or at a point in time. Performance obligations are satisfied over time if one of the following criteria is satisfied:

  • the customer simultaneously receives and consumes the benefits provided by the Group’s performance as it performs;
  • the Group’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced; or
  • the Group’s performance does not create an asset with an alternative use to the Group and it has an enforceable right to payment for performance completed to date.

The Group has determined that most of its contracts satisfy the over time criteria, either because the customer simultaneously receives and consumes the benefits provided by the Group’s performance as it performs (typically services or support contracts) or the Group’s performance does not create an asset with an alternative use to the Group and it has an enforceable right to payment for performance completed to date (typically development or production contracts).

For each performance obligation to be recognised over time, the Group recognises revenue using an input method, based on costs incurred in the period. Revenue and attributable margin are calculated by reference to reliable estimates of transaction price and total expected costs, after making suitable allowances for technical and other risks. Revenue and associated margin are therefore recognised progressively as costs are incurred, and as risks have been mitigated or retired. The Group has determined that this method faithfully depicts the Group’s performance in transferring control of the goods and services to the customer.

If the over time criteria for revenue recognition are not met, revenue is recognised at the point in time that control is transferred to the customer, which is usually when legal title passes to the customer and the business has the right to payment, for example, on delivery.

When it is probable that total contract costs will exceed total contract revenue, the expected loss is recognised immediately as an expense.

Software licences

The Group sells software licences either separately or together with other goods and services, including computer hardware and implementation, hosting and support. Revenue recognition in respect of software licences sold as part of a bundle of goods and services is considered separately when the licence is determined to be a separate performance obligation. Software licences either represent a right to access the Group’s intellectual property as it exists throughout the licence period or a right to use the Group’s intellectual property as it exists at the point in time at which the licence is granted. Revenue in respect of right to access licences is recognised over the licence term or, in relation to perpetual licences, over the related customer relationship and revenue in respect of right to use licences is recognised upfront on delivery to the customer. A software licence is considered to be a right to access the Group’s intellectual property as it exists throughout the licence period if all of the following criteria are satisfied:

  • the contract requires, or the customer reasonably expects, that the Group will undertake activities that significantly affect the intellectual property; and
  • the licence directly exposes the customer to the effects of those activities; and
  • those activities do not result in the transfer of a good or service to the customer.

Contract modifications

The Group’s contracts are often amended for changes in customers’ requirements and specifications. A contract modification exists when the parties to the contract approve a modification that either changes existing or creates new enforceable rights and obligations. The effect of a contract modification on the transaction price and the Group’s measure of progress towards the satisfaction of the performance obligation to which it relates is recognised in one of the following ways:

  1. Prospectively as an additional, separate contract;
  2. Prospectively as a termination of the existing contract and creation of a new contract; or
  3. As part of the original contract using a cumulative catch up.

The majority of the Group’s contract modifications are treated under either 1 (for example, the requirement for additional distinct goods or services) or 3 (for example, a change in the specification of the distinct goods or services for a partially completed contract), although the facts and circumstances of any contract modification are considered individually as the types of modifications will vary contract-by-contract and may result in different accounting outcomes.

Costs to obtain a contract

The Group expenses pre-contract bidding costs which are incurred regardless of whether a contract is awarded. The Group does not typically incur costs to obtain contracts that it would not have incurred had the contracts not been awarded, such as sales commission.

Costs to fulfil a contract

Contract fulfilment costs in respect of over time contracts are expensed as incurred. Contract fulfilment costs in respect of point in time contracts are accounted for under IAS 2 Inventories.

Inventories

Inventories includes raw materials, work-in-progress and finished goods recognised in accordance with IAS 2 in respect of contracts with customers which have been determined to fulfil the criteria for point in time revenue recognition under IFRS 15. It also includes inventories in relation to which the Group does not have a contract. This is often because fulfilment costs have been incurred in expectation of a contract award. The Group does not typically build inventory to stock. Inventories are stated at the lower of cost, including all relevant overhead expenditure, and net realisable value.

Contract receivable

The contract receivable represents amounts for which the Group has an unconditional right to consideration in respect of unbilled revenue recognised at the balance sheet date and comprises costs incurred plus attributable margin.

Contract liability

The contract liability represents the obligation to transfer goods or services to a customer for which consideration has been received, or consideration is due, from the customer.

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